Mountain Associates Reform of capital expenditure regulation Bruce Mountain Mountain Associates

Content Review of the current capex regulatory contract –Description –Incentive properties –Administrative requirements Is there a better way - how could we think about this? The ACCC’s suggested “ex-ante cap” approach: description, questions & answers

Mountain Associates Current regulatory contract: Description Commission’s Code obligations: –Economic incentives for efficient investment. Commission’s Draft Regulatory Principles –Step 1: Determine capex forecast and set revenue cap accordingly. Capex forecast is only “ball-park” estimate of “efficient” investment; –Step 2: Assess prudency of actual expenditure at end of regulatory period based on “good industry practice”. Roll-in “efficient” investment into RAB. “Ex-post” optimisation

Mountain Associates Current regulatory contract: Incentive properties But will threat of ex-post optimisation cause TNSPs to invest efficiently … –what if optimisation threat isn’t credible – would TNSPs still invest efficiently? –what if optimisation threat is credible – surely TNSPs would seek regulatory consent before undertaking major investments? (In which case, is an ex-post regime sustainable?)

Mountain Associates Current regulatory contract: Incentive properties Also, does existing regime only offer a stick (i.e. no carrot) to TNSPs: –if actual capex < forecast capex: risk that regulator will take away part of the “underspend”; –if actual capex > forecast capex: risk that regulator will make them absorb part of the “overspend”.

Mountain Associates Current regulatory contract: Administrative requirements What needs to be done to assess the prudency of past investments? –Assess whether bona fide need for investment; –Assess whether most efficient project chosen; –Assess whether most efficient project delivered. The assessment must only take account of what the TNSP knew (or should have known) at the time it invested.

Mountain Associates What does this mean in practice? –From 1999 to 2004, TransGrid invested in more than 60 separate transmission augmentation projects and hundreds more replacement, IT, and “support the business” projects. Each project should be assessed. –Prudency judgements requires that regulator can credibly “second guess” TNSP decisions. This means capability in transmission planning & engineering; environmental and local planning regulations; the ability to judge what corporate entities could be expected to achieve etc. Current regulatory contract: Administrative requirements Ex-post assessments are inevitably highly intrusive, subjective, time consuming (for both regulator and TNSP) and expensive.

Mountain Associates Developing and evaluating alternative regulatory contracts: variables for consideration –Ex-ante vs ex-post –Project-specific vs basket –Variable price vs fixed price

Mountain Associates A range of possible capex regulatory contracts “Fixed price” contract “Variable price” contract Basket of projects Individual projects VENCorp US Public Utility Commissions (PUCs) Ofgem UK DTe Holland NVE Norway Ofgem Ofwat VENCorp

Mountain Associates Evaluating alternative regulatory contracts Administrative requirements Strength of efficiency incentive Uncertainty – regulatory risk Intrusiveness Predictability Impact on service standards & reliability Decision variables Regulatory failure Information asymmetry

Mountain Associates The ACCC’s suggested direction for capex regulatory contract “Fixed price” contract “Variable price” contract Basket of projects Individual projects VENCorp US Public Utility Commissions (PUCs) Ofgem UK DTe Holland NVE Norway Ofgem Ofwat VENCorp ACCC’s current suggestion

Mountain Associates What’s the difference between the ACCC’s current suggestion and the existing regulatory contract? Existing regulatory contractACCC suggestion on possible regulatory contract When prudency is assessed Ex-postEx-ante Basis for determination of amount to be rolled- into RAB Ex-post prudency assessmentBased on actual spending (subject to cap) except for projects excluded from cap Extent of project-specific prudency assessment All projects meant to be individually assessed Limited - TNSPs free to allocate expenditure under cap (except for projects explicitly excluded from cap) Nature of efficiency incentive Threat of ex-post optimisationCap provides upper limit on spending. Incentive to spend efficiently under the cap depends on service incentives and planning standards IntrusivenessPotentially highly intrusive if rigorously implemented Intrusive assessment generally limited to projects excluded from the cap Administrative requirements Considerable if approach rigorously implemented Still significant but by comparison should be much lower

Mountain Associates Q&A on the Commission’s suggested direction for reform What if demand much higher than expected - setting a fixed cap places reliability and service at risk? Conversely, if the cap too high, TNSPs profit at expense of customers? Why is suggested arrangement less intrusive than the existing arrangement – both require assessment of efficiency?

Mountain Associates New arrangement provides no incentive for efficiency – why not simply investing in all the “marginal” projects first and then simply come back to ACCC for more money? Existing ex-post approach provides stronger customer protection because the ACCC retains the power to optimise? Q&A on the Commission’s suggested direction for reform

Mountain Associates Project-specific approach means the Commission can apply stronger efficiency incentive than it can with a “basket of projects” approach? Shouldn’t ACCC simply exclude all large and uncertain projects from “ex-ante cap” – this would allow a more accurate specification of the cap and greater protection for consumers? Q&A on the Commission’s suggested direction for reform

Mountain Associates The last word … “A regulator is supposed to take the punch bowl away before the party gets out of hand. The impact of its actions is blunted if it waits until the miscreants are numb with remorse before bursting into the room and issuing fire and brimstone denunciations.” Financial Review editorial on APRA’s report into the NAB.